Pension funds should be “extremely cautious” when investing in illiquid assets, as rising interest rates and falling stock markets increase the likelihood of needing to access cash quickly, the OECD has warned.
In the new era of low interest rates, pension funds are pouring money into alternative investments, such as infrastructure projects and private equity, in an attempt to escape the low yield available in government bonds.
But these investments are usually illiquid, meaning that the funds cannot be quickly converted into cash when needed. While there has been little funding to do this over the past decade, the UK pension crisis in October exposed how rising interest rates can change that.
“There are calls now for greater flexibility in terms of regulation [defined contribution] plans to invest in illiquid and infrastructure and this is good,” said Pablo Antolin, chief economist in the private pensions unit of the OECD’s Division of Financial Affairs. “But we must also be very careful because the issue of liquidity is very important in the management of investment strategies.”
In addition to liquidity risk, the OECD warns that the level of diligence required for alternative investments may exceed the reach of smaller funds.
“When you have a large pension fund, with a large investment team, which is more highly qualified, they can afford to make that choice and assess the illiquids well enough to introduce them,” said Antolin. “But small and medium pension funds cannot and need financial instruments to invest . . . What I have seen is that there are not many financial instruments that can invest in illiquid and infrastructure.
The warning comes as pension funds’ appetite for alternative investments shows signs of slowing. In December, BlackRock, the world’s largest asset manager, said the role of private assets, which spans everything from infrastructure to personal credit, becomes “more important than ever” as more companies turn to return.
Allocations to alternative assets have brought benefits to global public pension plans.
For example, the Virginia Retirement System, which has 778,000 members, reported common stock holdings and fixed income down 14.8 percent and 10.6 percent for fiscal year 2022. In contrast, real assets and private equity returned 21.7 percent and 27.4 percent during the same period.
Almost half of public pension funds globally with assets of more than $3tn plan to increase their exposure to alternatives, according to a new survey by the Official Monetary and Financial Institutions Forum (OMFIF).
Assets that provide a hedge against inflation, including infrastructure and some real estate, are among the most desirable, the survey found.
“Given this stark outperformance and lingering concerns between them [global pension funds] about inflation, it is not a surprise that there is an appetite to move more to real assets and private equity, “OMFIF said in an independent forum for the central bank, economic policy and public investment.
However, OMFIF points out the risks in this approach.
“The pursuit of higher returns in a relatively illiquid market gives funds less flexibility to change their strategy in the future,” the report said, adding that “the recent UK pension crisis suggests the need to hold liquid assets as a way to raise cash over time.” that’s bad.”.